Mosaic Software has an opportunity to invest $10,000,000 in a new engineering remote-control system for offshore drilling platforms in partner­ship with two other companies. Financing for Mo­saic will be split between common stock sales ($5,000,000) and a loan with an 8% per year inter­est rate. Mosaic’s share of the annual net cash flow is estimated to be $1,115,000 for each of the next 6 years. Mosaic is about to initiate CAPM as its com­mon stock evaluation model. Recent analysis shows that it has a volatility rating of 1.05 and is paying a premium of 5% common stock dividend. Risk-free government bond investments are currently paying 4% per year. Is the venture financially attractive if the MARR equals (a) the cost of equity capital, and (b) the WACC? (Note: Refer to problem

10.52 for further analysis of this investment opportunity.)

What will be an ideal response?


(a) Find cost of equity capital using CAPM.

Re = 4% + 1.05(5%)
= 9.25%
MARR = 9.25%

Find i* on 50% equity investment.

0 = -5,000,000 + 1,115,000(P/A,i*,6)
i* = 9.01% (RATE function)

The investment is not economically acceptable since i* < MARR.

(b) Determine WACC and set MARR = WACC. For 50% debt financing at 8%,

WACC = MARR = 0.5(8%) + 0.5(9.25%)
= 8.625%

The investment is acceptable, since 9.01% > 8.625%.

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